Napster vowed to let the band play on yesterday despite a federal appeals court ruling that said the company could be liable for enormous monetary damages if it continues to let Internet users download copyrighted music for free.

In rejecting almost all of Napster's legal defenses, a panel of three judges on the Ninth U.S. Circuit Court of Appeals in San Francisco yesterday found that Napster's service "knowingly encourages and assists" millions of people in violating the law.

The judges agreed with the record industry's arguments that the existence of Napster cuts into sales of CDs to college students and also harms the recording companies' own efforts to distribute music online.

"This is a clear victory," said Hilary Rosen, president of the Recording Industry Association of America, a trade group.

However, the judges did not restore an earlier U.S. District Court injunction ordering the company to eliminate all copyrighted music from its system. Instead, the appeals court sent the case back to the lower court, saying that record companies have the obligation to first notify Napster specifically about which music is being illegally copied.

"Napster, however, also bears the burden of policing the system..." wrote Chief Judge Robert Beezer. If Napster refuses to take action, the District Court could then reissue the injunction, which would essentially put Napster out of business.

"Napster is not shut down, but under this decision it could be," the company said in a statement. "We will pursue every avenue in the courts and the Congress to keep Napster operating."

Napster users, which the company estimates to be about 10,000 per second at peak times, can download digital copies of thousands of commercially released albums and songs without paying for them. Napster argues that it is not causing any economic harm to the recording industry, only allowing music fans to sample music before deciding to purchase it.

This clash of business, culture and free speech was unleashed in 1999 by Shawn Fanning, then an 18-year-old college student who wrote the source code for the program that allows computers to share files. He called it Napster, the high school nickname he got because of the texture of his hair.

The Napster case is the first big battle over how copyright law should be applied in cyberspace, and its ultimate outcome is likely to shape how music, movies, art and books will be distributed online.

But both sides realize that public opinion about whether the same rules should apply to the Internet is just as important as the court decisions. "Our hope is that when this decision gets read and talked about, the people who would be inclined to do the same thing now won't do it," said Leon Gold, a Manhattan trial lawyer that represented one of the recording companies.

Even if Napster is stopped, it may already be too late to change the expectations that online music should be free, said Nicholas Economides , a professor at New York University's business school. "There will be a proliferation of alternative programs and to shut them down the music industry will have to start suing individual consumers, their own customers," he said.

Also, a renegade company could set up a similar operation overseas in a country that is not bound by U.S. copyright law. "Given the nature of the Internet, even if it is stopped in the U.S. it can survive someplace else," Economides said.

Some of the alternative programs, such as Gnutella and FreeNet, which make it extremely difficult to identify users, are expected to benefit if Napster is shut down. "I will definitely just download entirely from Gnutella. I have already used it in the past," said John DeKenipp, 18, a Hofstra University freshman.

Napster lawyers said yesterday that they will appeal the panel ruling to the full Ninth U.S. Circuit Court of Appeals. "We look forward to getting more facts into the record," said the company, contending that the court ruled with "an incomplete record before it."

The legal jockeying means Napster could continue to operate for weeks, if not months.

Meanwhile, the delay allows time for a negotiated settlement with Universal, Sony, Warner and EMI, the companies that are suing it.

Another plaintiff in the case, Bertlesmann, invested $50 million in Napster on Halloween, saying it would drop its subsidiary BMG out of the case if Napster could convert itself into a fee-based subscription service by early summer, which Napster has agreed to do.